The risk of another Cyprus default over the coming years remains elevated due to very substantial risks to the country's economic performance and, as a result, the government's finances, Moody's Investors Service said in its annual credit report on Cyprus issued on Saturday.
This is reflected in the negative outlook on the Caa3 rating of the government, Moody’s said, adding that “although it is not the rating agency's central scenario, Moody's sees a material risk of a Cypriot exit from the euro area, which is captured in the Caa2 country ceiling.”
Earlier on Friday, President Nicos Anastasiades said that his government had reviewed all possible options and that any eurozone exit would spell disaster and the collapse of the Cyprus economy.
Moody's said in its annual report that its low assessment of Cyprus's economic strength reflects the country's narrow economic base and weak growth prospects. The rating agency anticipates the resolution mechanism for the banking sector will result in a significant downsizing of the activities of domestic banks, which will severely affect the economic performance of the island from 2013 onwards.
Moreover, the recession and the extended economic restructuring will have a lasting and profound impact on investor sentiment and on Cyprus's attractiveness as a financial and business centre, which will overshadow its traditional competitive advantages over the coming years.
In the absence of identified strong sources of growth, Moody's central scenario anticipates that the Cypriot economy will not return to positive growth before 2016. The rating agency also attached significant downside risks to this scenario. The possible exploitation of gas fields as well as a restoration of price and non-price competiveness in key export sectors carry some upside potential, but only over the long term.
Institutional strength is considered by Moody's to be low, reflecting significant deficiencies in the decision-making process, substantial shortcomings in the regulation and supervision of financial institutions, and passive fiscal-policy management. The significant delays observed in securing the Troika's financial assistance have, in Moody's view, exacerbated the precarious position of the country's financial sector, thereby increasing Cyprus's need for financial assistance. The rating agency's assessment is also supported by (1) the significant weaknesses identified by the European Commission with respect to the regulation of cooperative credit institutions and the supervision of credit risks in the banking sector; as well as (2) the poor track record of fiscal policy management, as highlighted by tax compliance concerns as well as forecasts that have proven to be overly optimistic.
Moody's assesses Cyprus's government financial strength as very low, given its already high debt burden and the substantial size of its projected fiscal needs. Immediate sovereign liquidity risks have been alleviated by the EUR 10 bln funding programme that was agreed in April between the Cypriot government and the Troika, and the exchange of domestic sovereign debt (which Moody's considered to be a default).
Nevertheless, the rating agency continues to believe that the sustainability of Cyprus public finances is far from assured despite the measures taken in the fiscal, financial and economic domains (as required by the programme). In particular, the country's sharp economic recession, which is likely to be lengthy, underpins Moody's view that the government is highly likely to miss the programme's fiscal targets. This is likely to also perpetuate a negative feedback loop for the economy. Given the importance of public services, this may also challenge future consensus on fiscal strategy.
Moody's said that Cyprus's susceptibility to event risk is very high and mainly stems from the crystallisation of contingent liabilities as well as the country's capital control policy.
Moody's still considers that there remain uncertainties regarding the magnitude of further recapitalisation needs for the financial sector given (1) the expected sharp deterioration in the operating environment which will erode asset quality; and (2) the behavioural responses of all economic actors to the shocks experienced by the financial sector, including the risk of financial disruption surrounding the timing and approach for lifting capital controls.
